A great business or trading mindset understands that hedging your bets is an important part of playing smart in a competitive market. A downturn in the economy is inevitable, but the question is when. That’s why the top investors are constantly bolstering their war chest and strategizing for future economic shifts.
Forex hedging allows a trader to minimize investment risks from potential market downturns. By hedging, you are protecting your investments against market fluctuations that would result in huge losses. This article will give you a detailed insight into hedging, explain how to hedge in Forex, and the advantages of Forex hedging.
What is Forex Hedging?
Hedging is an investment strategy employed to mitigate the risk of losing money on one investment by purchasing a second investment that performs in the opposite direction. It is a technique created to decrease the likelihood of adverse price movements in an asset.
In practice, the hedging technique takes place almost everywhere. Individual investors, portfolio managers, day traders and various corporations use hedging techniques to reduce the risk of exposure to various risks. Regardless of what type of investor you want to be, understanding hedging strategies will provide a better understanding of how investors and companies protect themselves.
The concept of hedging involves finding a way to protect yourself from losing a lot of money. Hedging is best understood as a form of insurance. By purchasing car insurance, you protect yourself against the possibility of future loss.
Traders and investors of all stripes use hedging to protect their positions against adverse market fluctuations. A hedging strategy involves opening a second position whose price is likely to have a negative correlation with the primary asset being held. This means that if the primary asset’s price moves adversely, the second position will react accordingly, thereby offsetting those losses.
What does Hedging mean in Forex trading?
Forex hedging implies the act of lowering or avoiding trading losses that occur from unforeseen situations within the Forex market. Despite the fact that hedging strategies can be used in all markets, forex is the most common, given the number of influencing factors involved.
Hope for the best, but prepare for the worst!
As you might know, the Forex market is the largest and most liquid financial market in the world. And with a diverse range of forex pairs available, the market becomes more volatile and can suffer from adverse conditions like changing interest rates or inflation. If you’re a Forex trader, you’re always thinking about how to protect your investments. Hedging is one way to accomplish this.
Forex traders have created a variety of forex hedging strategies in order to reduce the level of currency risk that is associated with economic data and indicators. Therefore, with the help of hedging, traders attempt to reduce their overall risk by buying additional assets or selling existing ones in order to protect their open positions. Adding hedging to your Forex trading strategy not only reduces the risk of losing profits but can also help you to protect your profits by keeping the trading losses at bay.
How Forex Hedging Works?
Forex hedging refers to the act of opening new positions strategically in order to protect your capital against adverse price fluctuations in the Forex trading landscape. Thus, Forex hedging allows traders to limit their losses while retaining some upside potential. Hedging strategies are usually preferred by experienced traders since they require an in-depth understanding of how financial markets work. Despite the fact that there is no certain way to eliminate risk completely, using a Forex hedging strategy can mitigate losses or limit them to a known amount.
Smart hedging means protecting returns on investment!
Some forex traders may choose not to hedge their forex positions – as volatility is considered to be an inherent part of forex trading – but it all depends on how much currency risk you are willing to take. If you anticipate that a currency pair is about to decline in value, and the trend will reverse eventually, then Forex hedging could be a useful tool since it limits your short-term losses while protecting the long-term gain.
Reasons to Hedge Forex Trades
Choosing your hedges carefully can help you make your trading plan more successful. It should only be undertaken by experienced traders who have an understanding of market swings and timing. You could quickly lose your account balance if you attempt to hedge without adequate trading experience.
Here is what you need to know about Forex hedging:
- It isn’t a magic trick that guarantees you profit regardless of what happens in the market
- It serves as a protection against potential damage caused by adverse price fluctuation in the future
Sometimes simply closing out or shrinking an open position can be the best course of action. Sometimes, however, a hedge, or even a partial hedge, seems to be the best choice. Consider what is most appropriate for your risk tolerance.
Hedging Strategies in Forex
Forex traders have a wide range of risk management strategies at their disposal to handle potential losses, and hedging is one of the most popular. Various methods of hedging are available in the Forex sphere. The three most effective Forex hedging strategies are as follows.
1. Forex Direct Hedging Strategy
A Forex Direct Hedging Strategy is a simple strategy which involves opening an opposite trading order to the current active trade. To illustrate, consider if you already hold long positions on a currency pair, but then decide to open a short position on the same currency pair – this is known as a direct Forex hedging strategy.
Let's say a Forex trader decides to purchase the GBP/USD currency pair using a "buy" order, then creates a "sell" order to profit from the potential rise or fall in price. As a result, the trader is hedging against any arising from possible price movement against his long position, which is more likely to reduce his losses.
The outcome of the direct hedging strategy would be a zero net profit or loss, depending on the costs associated with opening each trade. However, you can still keep your original position on the market and take advantage of the reversal. While many Forex traders would simply exit their initial position accepting the loss that they incurred, if you opt for a direct hedge, the second hedge position would profit you if the market moved against your first trade.
This approach has the benefit that it allows traders to protect their trades from potential losses while utilizing a completely legal method. However, some Forex brokers or platforms do not provide the option to create a direct hedge order, and they simply net off the two positions. Thus, it is a good idea to investigate and confirm the availability of hedging options before committing to a trading platform or broker.
2. Forex Correlation Hedging Strategy
Forex correlation hedging strategy is one of the popular methods of hedging Forex trades by using highly positively or negatively correlated currency pairs. A positive correlation indicates that when the price of one pair rises, the price of the other pair rises as well. While, a negative correlation means that if the price of one pair goes up, the price of the other pair will decline.
In this case, we can choose two Forex currencies that typically have a positive correlation (move in the same direction) and then take opposing positions. GBP/USD and EUR/USD are among the most commonly cited currency pairs with a positive correlation. This is due to the UK and EU relationship, both in terms of geography as well as political alignment – though the latter have changed recently.
Sometimes, the degree of positive correlation between those pairs is greater than 90%. That basically means that those two pairs move the same way 90% of the time. Therefore, if you had a long position on GBP/USD, you could hedge it using a short position in EUR/USD.
Here is an example of a GBP/USD and EUR/USD chart showing positive correlation hedging, for a better understanding of the currency correlation.
Consider the example of taking a short position on EUR/USD, but opening a long position on GBP/USD to hedge your USD exposure. Suppose the euro fell against the dollar, then your long position on GBP/USD would have lost money, but your EUR/USD position would have made money. The hedge would compensate for any loss on your short position if the dollar fell.
If you use a correlation strategy, you should remember that hedging more than one currency pair does come with a certain level of risk. Even though you hedged your dollar exposure in the example above, you would also have opened yourself up to shorting the pound and longing the euro. While a direct hedge would result in a net balance of zero, with a correlation Forex hedging strategy, one position might generate more profits while the other might incur losses.
3. Forex Options Hedging Strategy
Forex traders who do not want to open several positions for hedging can use options as an alternative. It enables them to buy or sell currency at a predetermined rate at a specified time in the future.
Let's say a trader decided it would be best to open a long AUD/NZD position at level 1.05 based on a thorough analysis. So far, everything looks quite straightforward. If the Australian dollar appreciates against the New Zealand dollar, let's say to the 1.07 level, then one can make some nice profits on the trade. But a trader who is concerned about possible losses, however, can purchase a put option at 1.00. For instance, if the Australian dollar falls to parity with the New Zealand dollar because of a sudden rate cut, weakening economy, or any other reason, the individual can purchase the option and close the position, limiting losses.
Many Forex traders are considering this approach as a cheaper alternative to other hedging methods. The reason is that if the market turns against the position, the premium paid will be much smaller than the loss that is otherwise likely to be incurred.
Forex CFD Hedging Strategy
CFD (Contracts for difference) have become a popular way to hedge forex (as well as other markets) due to the fact that they can be used to offset losses against profits for tax purposes, as well as to speculate on falling prices. CFDs allow traders to trade globally on thousands of markets, including multiple currency pairs, without having to hold any physical currency.
This type of Forex hedging strategy protects against inflation, fluctuations in commodity prices, currencies, and changes in central bank interest rates. Furthermore, it saves brokers time by allowing them to manage their portfolios in a volatile market environment.
Does Hedging work with automated trading?
Some traders find that hedging forex with automated trading tools, or robots, is beneficial for obvious reasons. Automated trading tools do the majority of the work for the trader once set up.
The idea of hedging in forex is based on the idea of opening several additional positions and buying and selling at the same time, along with trend analysis. You do all of this to protect yourself from sudden and unexpected market movements. Robots do exactly that, in an effort to keep your floating balance positive. As you will have multiple positions open at once, make sure you or your broker follows FIFO rules. That leads us to our next question:
Is Forex Hedging Legal?
Hedging with Forex trading is illegal in the United States and some regions. However, it is important to note that not every form of hedging is prohibited in the US, but the law is focused on the buying and selling of currency pairs at the same or different exchange rates. Due to this, the CFTC has implemented trading restrictions for Forex traders.
Despite this, forex hedging is legal with many Forex brokers worldwide, including those in Asia, Australia, and Europe.
Forex Hedging Summed Up
The process of hedging forex is often complex, and it requires a lot of preparation. You should keep these points in mind before you begin to hedge:
- Forex hedging involves opening new positions strategically to minimize the risk associated with currency fluctuations
- Most forex traders do not hedge their positions since they believe volatility is part of trading forex
- Popular currency hedging strategies include simple forex hedging, hedging with multiple instruments, and hedging with forex options
- To start hedging forex, you need to understand the FX market and decide what currency pair you will use, as well as how much capital is available to you.
- Before you start trading on live markets, it is advisable to test your hedging strategy with a Demo account.
Testing your Forex hedging strategies in a risk-free environment like a Demo account is always a good idea as it minimizes the risk of capital loss. Once you feel ready to perform your forex hedging strategy on real-time markets by opening a Cent account or a Standard account.
How to Start Hedging Forex Currencies in Simple Steps
You can make hedging a bigger part of your trading plan if you do it carefully. Here’s how to start Forex hedging in simple steps.
- Open a Forex Account. It is a very simple process to open a live Forex trading account and start trading now. Here’s how to open a Forex account with AximTrade – it only takes a few minutes, and so you can start trading live as soon as you’re ready.
- Choose a Currency Pair. With AximTrade, you can choose from a variety of forex pairs to trade, including major, minor and exotic currency pairs. Consider choosing a foreign currency whose inflation, interest rates, or GDP are dynamic if you wish to profit from market fluctuations.
- Determine your Forex hedging strategy. No matter which of the three strategies you choose, or if you choose something completely different, make sure you create a thorough plan with an end goal in mind.
- Keep up to date with Forex news. Forex traders can benefit from trading on forex news and economic announcements, as the market is constantly changing. Using our economic calendar, you can customize it to your personal preferences and keep track of any upcoming events that could affect your position.
- Define your Entry & Exit points and place a trade. In order to build a solid technical strategy, you should pay attention to the forex signals from trusted providers and make use of the technical indicators we provide.
Sometimes, even your winning strategy won’t work if you aren’t able to utilize a trading platform and place orders precisely, or if you use a fraudulent Forex broker. Choosing an ideal forex broker requires consideration of several factors, like regulatory compliance, the broker’s trading platform, available currency pairs and trading instruments, and responsive customer support. AximTrade review shows the benefits of trading with a regulated broker.